Revisiting the Two Levers Philosophy of Cash Flow Management

One of the major lessons I’ve tried to teach is that building your net worth comes down to two levers: Cash in and cash out. That’s it. That is the entirety of the game when you peer past the distractions and gaze into the heart of the mathematical reality. From a financial perspective, every action you take for your career or business ultimately only matters in so much as it someday serves to exert force on one of those levers so that more cash is flowing in than is flowing out, leaving a surplus.

It sounds so simple but when you see things through the focus of this particular lens, you can more quickly identify the actions that are likely to have an outsized effect, both for good or bad, on net worth. (Even in areas that might not seem evident at first. Case in point: Lehman Brothers wouldn’t have gone bankrupt if management had thought this way because the idea that they were always a phone call, or downgrade trigger, away from having to come up with significant cash resources relative to book value would have caused them to reorder the entire firm or else they’d have been unable to sleep at night.)

A common mistake I see when people attempt to honor this principle is a tendency to focus on sticker rates and/or first-order effects. They look solely at the immediate income or immediate outflow of a decision, ignoring other relevant cash flows that might result down the line which should be appropriately discounted. These include:

Life Cycle Costs: Five or six times in the past few years, we have discussed the work of the late Dr. Thomas J. Stanley, particularly his research that ultimately formed the basis for the publication of a tome called The Millionaire Mind. Self-made millionaires in the United States have a habit at looking at the total life cycle costs of a decision rather than the upfront outlay. This is one of the reasons that, dollar-for-dollar of income, engineers tend to end up with significantlyhigher net worths than the predictive models alone would indicate; from appliances to cars, shoes to computers, their personality causes them to disproportionately kick the proverbial tires, read reviews, and factor in things like maintenance costs, repair coverage, and gas mileage so they emerge with a much better picture of the long-term consequences of an outlay. Stanley used the example of shoes, finding that people who tended to amass money were more likely to do things like spend $300 or $400 on a good pair of Allen Edmonds, then have them rebuilt for a fraction of the cost throughout their lifetime. Despite the higher upfront outlay, it resulted in fewer overall outlays as the cost-per-wear was decimated.

Opportunity Costs: Making an outlay today to increase your income cash or decrease your outgoing cash must include an analysis for the opportunity cost of what that cash could have done. This is true in time as well as money. (One of the lessons my grandfather, who owned a demolition company in San Francisco, used to teach my dad was, “Never contract for a low-paying job just to stay busy. It will take up your time and make you unavailable to act when the really lucrative opportunity comes down the pike. Sometimes, to make real money you have to know when to turn down cash flow today.” There are echoes of this philosophy in Abraham Lincoln’s quip that if you tasked him with cutting down a tree in six hours, he’d use the first five to sharpen the ax.)

Sometimes, taking an action that looks like it will increase your cash-in will actually result in more cash flowing out down the road. The collapse of Wachovia comes to mind. So, too, does a story from my own life.

Years ago, an acquaintance of mine had a friend fall on her property during a regular visit. This friend-of-my-acquaintance broke her leg entirely due to their own negligence. One day, the acquaintance discovers she’s being sued for medical bills. Her homeowner insurance policy decided to settle since it was quicker and easier than a protracted legal battle.

Imagine my acquaintance’s surprise when the (now former but apparently not getting the memo) friend – who hadn’t made any contact at all – showed up for their regular visit as if nothing had happened. The friend was both bewildered and in disbelief that they were turned away at the door and told future contact was not welcome. “Why are you so upset?!” they wanted to know. “It was just a homeowner settlement. I wasn’t suing you, I was suing the insurance company to pay my bills.” (Conveniently ignoring, of course, the deductible as well as the now-higher homeowner insurance premiums that will result in tens of thousands of dollars in costs to my acquaintance over time.)

The friend became persona non grata in the community. It was as if she truly never stopped to consider the consequences of her action; to ask herself:

What sane person would invite her into their home?

What rational man or woman would have their children over for a play date or allow their own kids to drive her kids around after school?

What sensible employer would bring her onto the payroll knowing this was the way her brain worked?

Her total inability to understand basic incentive systems, reciprocity, networks of trust, and, as Munger might say, basic Kantian fairness, caused her to foolishly grab a little bit of money at an ultimate cost that was exponentially higher, if not difficult to precisely measure.

(A similar story was in the news yesterday when a Connecticut jury ruled against Jennifer Connell, the woman who sued her now-12-year-old nephew – a nephew whose mother, Lisa, died last year – for $127,000 after she broke her wrist when he jumped into her arms excitedly, professing his love for her, at his 8th birthday party. Connell reportedly said her injuries included such harrowing experiences as: “I was at a party recently, and it was difficult to hold my hors d’oeuvre plate,” Though she walks away a loser – poorer, in fact, due to her legal and time costs – even a full victory would have been dwarfed by the ultimate expenses and closed doors incurred due to committing what amounts to total and complete social suicide. The stupidity and immorality of the lawsuit, even if she needed the insurance money and was facing bankruptcy (there’s no indication she does or was but perhaps you’re inclined to charitably look for some potential justification where none exists), was so beyond comprehension, so outside the bounds of acceptable human behavior, that one writer didn’t believe it could be real, only accepting it after finding the case files – see FBT-CV13-6033608-S, CONNELL, JENNIFER v. TARALA, SEAN. Her face, her home address … it’s all over the Internet now. She will never outlive this. As long as she draws breath, this will haunt her. There is something deep in the human psyche of most ordinary, decent people that wants to see her destroyed. It’s visceral. She violated an unspoken rule woven so intrinsically into individuals at the genetic level that some commentators have argued only a sociopath wouldn’t understand. I’ve even seen arguments that her lawyers should be disbarred for accepting the case.)

This is the secret to the profitability of Berkshire Hathaway’s insurance subsidiaries. Present management knows this. It’s in the culture. While many other (not all) insurers are out there competing on market share, seduced by the big upfront cash flow that comes from writing a new policy, it will turn down a contract if it thinks the resulting outflows are insufficient to justify taking it onto the books. It’s the only sensible way to conduct business. You can go broke reaching for the cash.

On the Flip Side: Make Sure the Second and Third Order Effects Pay Off If You Do a Lot of Work for Nothing

Equally as important, you need to make sure you don’t give away your work product for free all the time for some vague notion of “publicity”, banking on payouts that come down the road but, somehow, never materialize. Sure, that can be an intelligent thing to do under the right circumstances – if it really is going to get you in front of a huge audience that can change your life in a heartbeat, driving sales of your products or services. If it won’t, you need to be like Dolly Parton; sweet, supportive and kind but fully aware of your value. If you don’t send her a check for her intellectual rights, she’s going to hunt you down, tie you to a fence, and horsewhip you until you cough up the coins you owe her. There’s a sense of basic fairness involved. Each person gets something from the exchange and is expected to honor it. No one is entitled to your work. You are not required to sacrifice yourself on some altar of martyrdom for the sake of your art. I see people do this all the time in music, literature, and technology, especially. I don’t understand it. They give away their best efforts for nothing, as if it were trash; accepting a pittance while allowing someone else to sell it for millions (in a few cases, billions).

Legendary science fiction writer Harlan Ellison once delivered a diatribe on the topic. It’s called “Pay the Writer”. (Warning: Language is NSFW.)

The point of all of this is to remind some of you that you need to look at the entire cash flow timeline and factor in all consequences that can be known about a decision when determining whether pulling a specific lever, at a specific time, is worth it. Some actions may appear to bring no immediate benefit but make you richer down the road. Others may look like they are profitable at the moment but send you straight to bankruptcy court (something corporate executives seem intent on re-learning every decade or so as they accept insane risks for a bit of extra revenue). Focus on the bigger picture and then make a decision. Intelligently implemented, it should improve the long-term economic results of your life materially.

It’s always odd to try and fit your life story into a few lines but here is the short version: My name is Joshua Kennon. I’m 35 years old. My husband, Aaron, and I met and fell in love as teenagers. After graduating from high school together, we moved from the Midwest to the East Coast where we studied classical music and a wide range of liberal arts. Later, we returned to the Kansas City area to be near family.

During our early twenties, we started several internet companies. We spent much of the next decade semi-retired and managing our own wealth thanks to the financial independence those businesses helped us achieve. I also wrote a lot during this time. In fact, the odds are good that you’ve directly or indirectly encountered me many times without realizing it. For nearly 17 years, I was the Investing for Beginners Expert at what was then known as About.com. I am the co-author of The Complete Idiot’s Guide to Investing, 3rd Edition.

Recently, Aaron and I came out of retirement to launch Kennon-Green & Co., a global asset management firm that specializes in value investing for affluent and high net worth individuals, families, and institutions. These days, we spend our time running and growing the firm, as we plan on it being the institution through which we pass on our own family’s wealth to our future children and grandchildren. The experience, particularly meeting such incredible people, has been one of the most rewarding of our lives. It’s a rare thing to have a career that allows you to not only do what you love for a living, but to do it with people you admire, respect, and like. We feel like two of the most blessed guys in the world.

This personal blog is a place where I talk about some of the things that interest me – cooking, finance, entrepreneurship, politics, history, economics. I’m really proud of the community we’ve built, in no small part because the typical reader around here is exceptional.

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